Regulation Can Create Moral Hazard

May 20th, 2011

There has been muchtalk about bailouts causing moral hazard over the last 2+ years. In an attempt to counteract the notion that when you get ‘too big to fail’, you will be bailed out, policy makers and regulators have been hard at work at new reforms to ensure the crisis never happens again.

However, the Economist just pointed out something that blew my mind (because I never thought about it before) and figured I would share it. Here is the passage:

Besides, the regulators’ reluctance to second-guess bank executives was well founded, because it can take them onto dangerous ground. If regulators underwrite certain strategies that seem safe, such as lending to small businesses or helping people buy houses, they may encourage banks to crowd into those lines of business. That can drive down interest rates and lending standards and push up asset prices. If enough banks pile into these markets, downturns in them can affect not just a few banks but the whole system. Paradoxically, the very act of signalling that a market is safe can make it dangerous. It also introduces a form of moral hazard, because banks and their creditors may assume that the government would be duty-bound to bail them out if a closely monitored institution were to fail.

Talk about damned if you do, damned if you don’t. Thank God I am not a regulator, because this type of paradox is just ridiculous.

The most common suggestion for getting rid of moral hazard has been to ‘break up the big banks’…..but with this new consideration, even if you break up a big bank into 3 smaller banks and all those banks crowd into a line of business deemed ‘safe’ by the regulators, that creates the same problem highlighted above.